A blog about reverse engineering, mathematics, politricks and some more ...

Friday, July 06, 2012

The Euro Crisis and Germany - or "The tale of the shoemaker, the baker, and his wife"

It was more than 2 years ago that Europe started struggling with the Europan Sovereign-Debt crisis, and still there is no end in sight. The crisis has created significant economic hardship for most of the debtor countries, but worse, it has poisoned the European political discourse and led to a re-emergence of petty nationalistic arguments that I had hoped we had gotten over.

In order to make sense of the complexity of the situation, I came up with a small cautionary tale to illustrate the causes for the credit crisis in a simple-to-grasp manner:

Picture a fairy-tale medieval town - small alleys, craftsmen, horse carriages etc. In our medieval town, we will focus on three people: The Shoemaker, the Baker, and the Baker's Wife. For as long as anyone can remember, the Shoemaker bought bread from the Baker, and the Baker bought shoes from the Shoemaker - both for himself, but also for his Wife, who is very fond of beautiful shoes.

At some point, though, the Baker had an idea: Since he spends literally all his time in his bakery, and rarely leaves the house, he decided that he doesn't actually need new shoes all that often. He thought about it, and decided that he could save a fair amount of money if he just used his old shoes, even though they were long past their prime. In addition to this, he had a long (and somewhat unpleasant) discussion with his wife, finally convincing her that she, too, should forego new shoes in order to save money. The wife was not happy about the entire argument, but eventually agreed when the Baker explained how rich they could end up being if they saved more.

When the Baker quit buying shoes, the Shoemaker could no longer make a living. He began dipping into his savings, but eventually, he had transferred all his savings to the Baker, and was essentially broke. So he walked over to his longtime friend, the Baker, and asked him for a loan. The Baker, having accumulated a fair bit of cash, and not knowing what else to do with the money, decided to lend the Shoemaker some money. In the Bakers' account statements, the debt owed to him by the Shoemaker was marked as an asset, so even though he gave the Shoemaker money, the Baker still got richer.

This cycle continued for years. Every year, the Baker's wife would ask whether they could use some of the money to buy some pretty shoes, and every year, the Baker convinced his wife that it is more prudent to not do so - and in order to impress her and show her the validity of his argument, he showed her the accounts, clearly showing that they were getting richer all the time.

And so the Baker kept on lending the Shoemaker money, and the Shoemaker kept on buying bread - and the Baker's wife continued to make the sacrifice of not buying shoes.

Eventually, the Baker and Shoemaker realized that there was no way the Shoemaker could ever pay back his debt. This, though, implied that the Baker hadn't actually gotten richer - all his money, accumulated by his and his wife's sacrifices, was gone.

The Baker lives in crippling fear that his wife will realize that the savings are gone. In order to deflect the fact that he is as much to blame for the situation as the Shoemaker, he vilifies the Shoemaker: The Shoemaker is lazy, doesn't work, doesn't know how to handle money. The Shoemaker, at the same time, vilifies the Baker, claiming that the Baker is trying to force the Shoemaker into poverty, and simply hates everybody that is not part of the family.

In this tale, there is really nobody that doesn't need to accept some of the blame, and adversarial relations between the parties won't help anyone.

I do not see how you can tie purchasing of goods and services to social responsibility. Those two are entirely different things and I am dismayed to see a very smart man such as yourself to tell the usual poor Keynesian logic of social good through spending in allegorical terms. They simply do not relate. The survival of any robust economical system depends on both the shoemaker and the baker being flushed. They eventually will be flushed no matter how far you go with spending to delay that outcome. Robustness is a feature of diversity. Diversity survives flushes and technocratic utopias don't. Easily proven fact.

The big problem in the EU situation is that the different countries cannot just reate an amount of money (which has to be reasonnable amounts to not devaluate too much the money). Any other country in the world creates money for state use, infrastructures, etc...In the EU, the ECB creates money, and lends it directly to private banks, for a near zero rate. The private banks then lend this money to the different states for rates of 3-15% (dependant on some obscure rating agencies). Of course, lending a state budget at 15% is not sustainable, basically, after some 10 years, all the EU states BELONG TO private banks. That is the case now, we are 10 years into the euro...

First, markets are statistical phenomena. You can't understand markets by looking at a small number of transactions between a small number of parties. You'd miss the power of small changes if everyone performs them, as well as the irrelevance of individual behaviors if everyone else doesn't think so.

Second, yout don't even try to build realistic behavior into your actors (which should really be classes of actors). Typical reactions of a shoemaker with demand problems will be, roughly in that order: try advertising, try modifying the products and services offered, try to cut cost, and if all else fails, go out of business.

Third, you seem to assume that the baker lends money without risk management and without alternative. In reality there will be more attractive investments than loans to a semi-bancrupt shoemaker. The baker might buy Google stock or real estate or helium or build a solar plant in the desert.

About Me

I like simple things. And complex things. And drinking beer with people like Fyodor Yarochkin.
I like South America. And some parts of Asia, specifically Kuala Lumpur.
I like French. I like Spanish. I'd like to like more languages.